Target Costing

1 Target Costing – An introduction

Going through the literature and careful analysis of introduction of this technique among other relevant costing techniques, especially the ones that are part of ACCA f5 syllabus, it is noted that this technique came after Product life cycle philosophy was introduced.

Therefore, we can conclude up to some extent that the developers or at least the environment in which this technique was developed must be aware of the different phases in the products’ life cycle. However, the obvious missing link was the customer itself in the production design and pricing decisions.

Target costing might be the first technique that considered the effect customer’s discretion and his affordability or capability to buy products in relation to prices offered by the organizations. Students will understand how this theory would have affected the decision making process in organizations once the customer was also made part or at least considered in making product and market related decisions.

That is why Target costing is standing at a complete contrast to traditional costing techniques, especially in setting product prices.

1.1 Target costing system Vs Traditional costing systems

First of all let’s just clear our minds on what is meant by “traditional”. Traditional basically represent the costing and decision making techniques used in such time in which production was material and labour intensive and overhead was hardly an important factor in production. Secondly, the marketing structure was heavily under the influence of monopolies and customer was either unaware or obstructed intentionally to go for alternatives. Thirdly, in the absence of research and development, extractors were basically the manufacturers and not much of value addition was done by the manufacturer and the same was made available to the customer who used to accept it as is because of lack of knowledge and technology. Fourthly, accounting was not much considered to be much helpful in decision making and its maximum role was of just a calculation tool and until that period not much of advancements were made. And the quantitative techniques that we are studying today were either in raw shape or simply absent.

In such situation we can understand that mostly the decisions would have been based on experience and overly subjective.

But this was a safe bet until the death of monopolistic market structure. And once, manufacturers were in competitive markets, they were not in the position to decide in a regular way and mostly end up making wrong selections different alternatives and even if the correct production plan was selected, wrong pricing decisions let them down.

Under traditional costing techniques, manufacturers were used to calculate the price of the product in the following steps:

  1. Calculate total cost by adding up all the costs incurred
  2. Add up the desired amount of profit. Usually by grossing up the cost using a certain profit percentage
  3. Get the sale price of the product

This way of calculating price is termed as cost plus pricing. We will be discussing several other ways of pricing later.

However, this methodology proved way too dangerous to be reliably used. And with the passage of time when overheads became the most significant costs of production, the flaws became bigger and bigger. The case of absorption costing deals with overheads cost can be considered as one of the major example. And if the costs are not accurate, all the decisions taken on such cost data might end up completely wrong.

Also, without including the major variable of the market i.e. customer itself organization’s realized that profit maximization is not simply making things good but selling these goods at optimum prices is mandatory.

This is what “secret management labs” at different places of the world before and after Second World War understood and used. Though the technique was not renowned and used until late 1970s when different car manufacturers of the world tried to win market share by producing such products that are not only according to customer’s demand but also at competitive prices.

This is where terms like “process reengineering” or “value engineering” were introduced and put to action.

2 How target costing works?

As said earlier, target costing is a retrograde approach to price the products. To decide the price, this approach starts from the customer’s perspective. As all the organizations are working to earn more profits, which is only possible if more and more customers are buying their products which on the other hand is only possible if customers are offered good prices.

Thus we can see at as a trickledown effect starting from deciding about what market segment and what percentage of total market size of such segment is to be captured. Once this is decided, it will help in deciding about what kind of product is in demand by target customers and with little more research, relationship price and demand can also be determined which will reveal the potential demand at different price levels. The price determined will be termed as target price.

This is a point to ponder that this is the first time that price is settled by going completely out of the way.

Once the price is finalized, organization will determine the profit level it requires considering the requirements of shareholders and other connected stakeholders. The profit determined is called target profit.

With target price and target profit determined, the cost at which our product must be produced can be calculated easily by simply deducting target profits from target price.

If we summarize the steps then it can be written as follows:

  1. Determine the price of the product
  2. Determine the desired profits
  3. Deduct desired profits from target price to find out the target cost

If we compare the above steps with the steps that were used under traditional methods, it is clear that target costing has just catapulted the whole course of pricing decisions.

However, this analysis is still too narrow to completely understand the reason why we have denied the usual decision pattern. The story of target costing does not end on calculating target cost rather it begins from that point onwards.

2.1 Target Costing – Detailed analysis

Target costing appears to be pretty straight forward technique. However, management should not let its simplicity to mean that its implementation will also be simple. The power points of target costing which separates it from traditional techniques can open many doors of opportunity but can also prove to be a fatal leap as target costing demands total integration of all the resources organization has and their alignment towards a common goal. Almost everything will be altered the way it was used to be done in traditional techniques. Let’s have a look what steps are required to be taken by the organization for its implementation and what can be the possible consequences.

STEP 1: Realigning market strategy and deciding about the product which is in demand or will be in demand. It includes market research and experimentation with buffer product to check the response of the market.

Understanding the market is not easy especially for small scale organizations as it involves huge investment in market research. Though existing products might provide a suitable insight about the characteristics of the future product, but still the data collected from such source might not be relevant and reliable. Also, the demand and expectations of customers vary from market to market and even age, gender, education, living standard and other economic factor. In such situations, it might be almost impossible to come up with such a product that WILL be in high demand. No one can expect future for certain.

For same reason, large organizations have a second strategy. Using advertisement they “educate” their future customers what they might need in future and once that stage is set for the product they launch that product. Though this strategy cannot promise future market of the intended product but at least organizations try to control the attitudes of the customer well in advance and thus are in a position of making customers believe that price was settled according to their expectations.

Step 2: Deciding an optimum selling price that is expected to secure a target market share

Once market is discovered (or created artificially as said in the previous step), then strategic management will decide about the market share it wants to capture which is dictated by the price at which a product will be sold. It might appear really a simple thing to do and completely connected with market and customer only which is not the case. Prices are decided by balancing the demand of the product and the resources organization has to meet such demand.

Certainly, low prices mean high demand of the product and might also mean higher profits (in case goods are inelastic) but does the organization have enough resources? Sometimes, even with resources present, organizations face difficulties in aligning them for example, management requires labour to increase efficiency or to work overtime but labour is not accepting it or the raw material required will not be available at the pace necessary to keep the process running or customer demands higher credit facilities.

Step 3: Determine the desired profit by balancing the risk factor and the expectations of stakeholders

Desired profit does not mean just any profit that management wants. Whatever management wants is sometime not even in control of management itself. Profits are what businesses exist for and essence of any activity organization is undertaking. But the management itself gets the dictation from different stakeholders especially the investors whose money is at stake. If the future product or production process itself involves more risk, stakeholders will demand higher returns to balance the risk.

Therefore, more risk means more profit requirements which ultimately will either push prices up or press the costs down. Determining profits is a crucial step especially in cases where customers and also the stakeholders are not ready to give up their demands.

Step 4: Calculate target cost by deducting desired profits from target price.

Again, this is not just add and subtract thing and is much easier to be said than done practically. Costs are complex items. Just imagine some are controllable and some are uncontrollable. Some are connected with production and some are connected with time. Some are situation dependant and some not. Some are normal and some are abnormal.

The depth of costing decision depends on the situation and also the capability of the management. Also what variables are considered as part of target cost and what are treated independently because of controllable and uncontrollable nature or will management ignore this altogether.

Step 5: Determine expected costs under the current scenario and best possible efforts.

Mostly the target cost is not the same or even close to the current operational costs. Usually target cost is like a challenge to achieve. But before launching towards target cost, current setup must be examined.

Doing this will reveal things needed to be done and the extent of change. Or does it simply takes to replace the whole setup with a new one? All of similar questions must be decided only after evaluating the existing setup. It will help us understand the cost structure and the components that we are using to make a product. This evaluation must be coupled up with market research and future expectations of market and technology that we can have later in time.

This step must be undertaken with great care and analysis must be as detailed as possible. Qualitative data sometimes overlook or is unable to provide relevant information so non-financial techniques can also be employed to make the analysis more meaningful.

This analysis should not be limited only for production cost but it should extend the way things are managed the costs and should include all such costs that does not form part of the product cost like admin and selling cost. This in depth analysis will help us in great deal in our next step in which we are going to strategize whether we need to make changes in our management structure, whether we need to train our staff for our next setup according to the required skill level, whether we need to locate a new market of factors of production and so many other things that we will consider in the next step.

Step 6: Realign current cost (expected cost) with target cost. A continual process of reducing cost so that more value is added by putting less and less cost. In other words different departments will come together to come up with such product design in which any kind of cost in terms of wastage, losses etc are designed out of the process.

This phase will either make the whole thing going or will break it completely. The most important and time consuming phase of whole implementation process. One thing to understand is that the steps written here don’t occur in sequential order rather most of the steps are carried out simultaneously and change in one aspect will affect the whole system. For example, target cost cannot be finalized without determining the product specifications. Similarly, product specifications cannot be finalized until the whole research work is not complete.

This phase is heavily dependent on the prototypes and information collected from such test runs. If the information gathered is not accurate or if the information is not simulated by considering all the relevant factors that will affect the demand and supply of the product after commercial production then it will be really difficult to come back at design stage and make the improvements. That is why it has been established that design stage of the product takes 70-80% of the cost and time in the product’s life cycle.

Even though the costs cannot be standardized completely in advance as they may go up or down with the passage of time but by entering in annual contracts with suppliers and customers might help clearing up the “uncertainty fog” above the prospects.

One thing that might get ignored at this stage and will pose problems once product is in mass production phase is that the cost structure and everything associated with the product must not be that much hard planned that it cannot be altered in anyway later. It must be flexible and must have the ability to adopt the changing scenario. This depends on many factors like nature of the product, market and resources used.

In this phase, staff from different departments sit together and will try to bring the overall cost of the product to be equal to target cost. This involves tense discussion between departments, customers, stakeholders and so on. Some students might find it difficult that why all these parties are considered again as we have already dealt with customers in price setting step and stakeholders in profit determination step.

Management might have to renegotiate with customers so that price might be improved or their quality expectations and product specifications might be lowered so that cost reduction is not that much of a problem.

Similarly, if much of the revenue is consumed towards satisfying investors then there will be much smaller headroom for the costs which might make it impossible to produce the product with required profit margin.

Once the satisfactory equilibrium is reached between all the variables and expectations then implementation can enter next phase.

Step 7: Reevaluate the economic and market conditions and decide!

Once the research and development phase is completed management has to decide whether to launch the product or not. This might require revisiting the whole setup once from the very beginning and taking a fresh look. Sometime is important by the end of finalization of the product things might have changed a lot and might need fine tuning of the plan and the product itself.

If final review tells that plan is still feasible and doable then management will start the mass production.

Step 8: Monitor the flow of costs during commercial production and maintain competitive costs

Once the product is driven in commercial production than management must be constantly monitoring the production process to assess whether the costs are incurred as planned or not.